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Comparing Fixed Annuities & Certificates of Deposit

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Hand Painted Piggy BankWhen I first opened up my Vanguard account a few years ago, I requested all sorts of fancy investment brochures. I had just started Bargaineering and had a voracious appetite for financial information and fancy words like annuities, in all their flavors, really intrigued me because I had never heard of them. One of the books I requested was Vanguard’s booklet on annuities, an investment vehicle I would later learn is rife with ripoffs and unscrupulous characters.

I never read the booklet until my wife and I were cleaning out some documents and they remind me a lot of long term CDs, with a few wrinkles. If there’s anything I’ve learned in the last few years is that the financial community has a funny way of coming up with a million different ways to do the same thing, if only to be able to say they have a hot new investment option for you!

Brief annuity primer: An annuity, in this sense, is a financial contract structured as an insurance product where you pay a lump sum (for single payment annuities) or regular payments (regular payment annuities) and the life insurance company pays out a series of payments in the future.

Deferred Fixed Annuities

So what is a deferred fixed annuity? A fixed annuity is one where you are guaranteed a certain rate of return over a specified period of time. (Variable annuities have floating interest rates, typically tied to the performance of some benchmark) You buy the annuity and it accrues at the agreed on interest rate. You can withdraw funds from the annuity a variety of ways, either lump sum, conversion into an income stream, etc. (for the purposes of my analysis, I use the Vanguard Fixed Annuity Single 5 as my baseline)

Certificates of deposit, as you may remember, are little less flexible. With a CD, you deposit funds into a CD account and it grows at the specified interest rate until the CD matures.

Similarities

Guaranteed Rate of Return

With both products, you are guaranteed a rate of return for a specified period of time. The rates are pretty comparable. At the time of this writing, the rate for the Single 5 was 3.60%. The highest rate 5-year CD rate I found at a bank was GMAC Bank at 3.50%, at a credit union it was Pentagon Federal at 4.00%.

Income Taxes (Over 59.5 Years of Age)

In general, the gains in an annuity are taxed as ordinary income, just like a CD. There is some math you’ll need to do to calculate how much of your annuity is excluded based on interest rates and such (explained in IRS Publication 939, General Rule for Pensions and Annuities) but your gains are taxed as ordinary income.

Fees

The biggest red flag people talk about when you ask them about annuities are the fees. The fees can eat into your state rate of return significantly and that’s where a lot of people get caught. At least with Vanguard’s Single 5, there’s no loads or sales commission. “Buying” an annuity is free, there are no sales loads commissions. Any management or administrative fees are incorporated into the interest rate, so you can make a fair comparison between interest rates.

Differences

Deferred Income (Taxes)

The main appeal of an annuity is that it can grow tax-deferred. You are not required to withdraw anything from your annuity whereas you are required to recognize income from your CD as it accrues, even if you don’t get it deposited into your account. With an annuity you can simply renew it and continue to benefit from tax-deferred growth.

When you are ready to withdraw it, you can convert it into an income stream and continue to stretch out the deferral of taxes. Again, this is something you can’t do with CDs.

The main drawback of annuities is that they are designed as retirement vehicles and thus suffer from the same tax handicap that other tax-deferred vehicles are subject to. If you withdraw funds before the age of 59.5, you will be subject to a 10% penalty on the taxable amount.

Investment Safety

Banks, and thus your CD, are protected by the FDIC, a federal government entity. Insurance companies, and thus your annuity, are protected by state guaranty associations (what happens if my insurer goes bankrupt?). For CDs, your protection is up to $250,000; with your annuity, your protection is up to $100,000 (calculated as the annuity’s present value).

Withdrawal Options

The big difference with an annuity and a CD is that with an annuity you can withdraw some of your investment without much of a penalty. With the Single 5, you can withdraw up to 10% of the interest each year without penalty. If you want to withdraw more, there’s a surrender fee that decreases each of the first five years. In year one, you have to pay 6% of your withdrawal over 10%, then it’s 6% in year 2, then 5%, 4%, 3%, and finally 0% in year six and beyond. With CDs, you typically have to close the CD and incur a penalty of up to 6 month’s interest.

Minimum Investment

You can open a CD with as little as $1 in some places but if you want to open Vanguard’s Single 5, you’ll need $10,000 or more.

Hopefully I’ve correctly covered the similarities and differences between the two. A fixed annuity is an interesting investment/insurance vehicle and while I’m not sure it’s a good option for us right now (seeing as we’re many years away from 59.5), it’s certainly better to understand it.

Do you have experience or insight into this? Did I miss a big difference or similarity?

(Photo: jbhill)

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16 Responses to “Comparing Fixed Annuities & Certificates of Deposit”

  1. Nice post – I think annuities have a bad rap because they used to mostly benefit sales people – who would get large commissions for them. It looks like the Vanguard annuity is a relatively safe way to add this type of safe income to your portfolio. I would just add, as an investor, to make sure you read the prospectus and understand how the company managing the annuity is making their money before you proceed.

  2. shadowdcs says:

    Thank you for the helpful post. The only thing I would add is to make sure that you are maxing 401k and/or IRA investments before investing in an annuity since you can get the same tax deferred growth benefits plus a broad range of investment options without the potential downsides of annuities like fees and charges.

  3. reinkefj says:

    Just got out of a variable life insurance policy that was held in a irrevocable trust, imho it has some of the similar objections to an annuity. (The same insurance company markets both. Hence the easy comparison.) Vanguard is the low cost version of everything. I’ve NOT studied those offerings.

    There are fees and then there are “fees”. It’s impossible to root them all out. Fees impact performance. The mutual funds, that are available, have their own set of warts. (Read Eddleman’s Lies about money to see the warts. He gets most of them.) ALL you can do is look at their performance as it compares to their peers in the market place. I found their performance to be dismal.

    Eventually, I gave up. It’s hard to imagine the usefulness of an annuity in today’s interest rate climate. Now if it was during the Carter administration with 21% interest rates, then I’d be trying to lock those in forever.

    Your mileage may vary.

  4. My Journey says:

    Great post….

    The only thing I would emphasize is that with an annuity you can turn on the stream of income.

    So if you were to put in 100 bucks a month for 10 years lets say, you would then have a pot (100*120 montly installments * Growth) that can be taken as a lump sum or as a stream of income for a time cetain, or for the rest of your life.

  5. eric says:

    I think the reason annuities are so bad is because they make sense for only a small minority of retirees and even then you have to make sure not to get caught by all the little rules and such.

  6. My Journey says:

    Eric,

    I have to respectfully disagree. Annuities help out a lot of people regardless of age depending on their certain circumstance.

    If anyone product had absolutely no use it would not be in the marketplace. I refuse to believe that those selling them (and I know a lot of them since I work in the industry) are some sort of Jedi Master able to convince truck loads of people to buy them.

    Yes, there are fees, but there are also guarantees made by insurance companies, some of which, are rated higher than your local government in terms of safety.

    • Glen says:

      How true this. I too work in the industry and ask those interested in choosing say a bank CD over an Annuity should do their homework and go back to the depression and look closely at the number of bank failures compared to the number of insurance company failures.

  7. barry says:

    While I disagree with your disagreement My Journey, I undestand your point.

    If there were no other alternatives to Annuities that are still guaranteed AND have lesser fees, then the reputation that such instruments have now would be un-earned.

    And, without casting aspersions upon the entirety of Life Insurance professionals, I don’t think the majority of annuity investors are Jedi-anything.

    So, I agree with Eric.

  8. Chris Miller says:

    Thanks for this post. A lot of really solid points. There are a lot of very good annuities out there and your point “Annuities help out a lot of people regardless of age depending on their certain circumstance” in the comment section is well taken.

    I think the most important thing to keep in mind is that their are products out there that are going to be right for some people and not be right for other. Be an educated consumer and make sure your financial adviser is well versed in what your needs are as an investor. Appreciate the good content!

    Thanks!
    @annuitymaven

  9. The fixed annuities that you cover in the post are relatively simple instruments and the best net yields are going to come from low cost providers since investment returns are predicated upon the performance of the general fund of the insurer less fees. For the most part, if you stick with a low-cost provider and ensure you actually need the product, you won’t have too many problems. Just remember that fixed annuities, like CDs, are participating products in the sleeping dog game. After the initial guaranteed period, you won’t necessarily find yourself with a good or even competitive rate, so you should shop each year that your annuity or CD is out of surrender/penalty.

    Also, sometimes you’ll see fixed annuities quoted for a guaranteed x.xx% yield for 3 years, but will have a surrender period of 5 years. This demands that you do some homework and determine the minimum yield to surrender. If it’s guaranteed at 3% for three years and the minimum guarantee on the contract is 1%, then you’ll get a total of 11% guaranteed (3%, 3%, 3%, 1%, 1%). Anything above that is hoping the insurer will pay above the guaranteed rate which is far less often than you might think. This is one area where CDs are much clearer than fixed annuities.

    • Glen says:

      I do agree , but you need to also consider your age and determine if you have the risk tolerance to invest in a riskier investment and how long a period you might have to try and recover your losses if they occur. I agree banks have been around for ages, but it pays to do your homework. There have been far more bank failures than insurance carriers as far back as you wish to go.

  10. I agree with the others that I would look to invest in other tax deferred vehicles like IRAs, 401ks, 529 plans for kids college, etc first before I would look to an annuity. Those usually have more investment options and lower fees than annuities.

    After I had maxed all my contributions and I still wanted to put away some more tax deferred money for retirement then annuities are a solid option. Even Dave Ramsey agrees although he prefers to invest in real estate himself. But for those of us who don’t have the desire or the chops to make it in the real estate market annuities offer another tier of retirement savings.

  11. Jack says:

    I believe you missed one important point about CDs. CDs can be placed under an IRA, which allows them to be tax deferred, including interest – until withdrawal.

  12. Anonymous says:

    Under the area where you say there is a penalty of 10% if you withdraw money from an annuity prior to age 59 1/2 you are incorrect. You can deposit money into a flexible deferred non-qualified annuity and withdraw without paying a 10% penalty.

    I have available two carriers, one with a seven year and another with a 10 year surrender penalty. If you deposit money into the one with a 7 year surrender and withdraw at age 47 there is no penalty. The one with a 10 % surrender charge and withdraw at age 50 there is no penalty. All you pay is taxes on the actual money withdrawn nothing more. Also both grow taxed deferred.

  13. Anonymous says:

    I do believe the interest earned on Annuities are taxed as ordinary income and so is the interest earned on CD’s, but CD’ s are taxed each year whereas Annuities are note and therefore you earn more money. The reason most people wait until age 65 or after they retire is most of the time they are in a different or lower tax bracket and taxes on income are lower.


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